How Chinese Yuan Moves Affect Forex Positions

by: TradingHelpDesk

China’s growth is mainly dependent on exports with a trade balance of around $200Bn a year. Each swing in western demand effects Chinese growth. Last year with the credit crisis at its climax Chinese exports slumped and with it Chinese unemployment surged and growth slowed. However, since in China political stability is directly linked to constant growth, this is not something the Chinese government could afford. The Chinese government quickly stepped in to tackle the economic spiral with an announcement of an outstanding $586 billion of stimulus.The result was a strong boost in Chinese demand with imports of commodities such as coal, iron ore and copper surging.

The China effect is on such a global scale that China’s growth prospects affect the entire global risk play for equities, bonds and forex.

In the FX space, it is the commodity currencies such as the Aussie and the Kiwi that are most sensitive. However the commodity currencies are not alone. The Yen, for example, is also strongly affected by Chinese sentiment. Japan’s main export to China is consumer goods. Unlike the Aussie and Kiwi, the Japanese Yen is a counter risk trade and tends to be in opposite divergence to the Chinese growth story-- although not always. The Yen’s divergence with China can sometimes be more complex than a simple risk play, as detailed below.

So how could your FX position be affected?

Watch the Chinese policy on the Yuan: Although the Yuan exchange rate is controlled by the Chinese authorities, investors look at the Chinese Yuan exchange rate as an indicator of Chinese growth. During the last decade the Chinese central bank allowed the Yuan to appreciate more than 15% against the dollar. However, since the credit crisis erupted, Chinese authorities left the Yuan exchange rate at 6.82 per Dollar. This was to keep Chinese merchandise cheap, encourage growth and tackle unemployment. As long as the Chinese authorities are worried about unemployment, the Yuan will be kept low.

Why is the Yuan exchange rate important? If the Chinese government allows the Yuan to appreciate, it means the Chinese government is bullish on the Chinese economy and therefore all China linked trades should gain and risk appetite in general should rise.

Watch out for a Chinese tightening policy. With a government target of above 8% growth for the economy in 2009, a 9.1% YoY growth signals the Chinese stimulus has been successful. In fact, it has been too successful- with real estate prices surging and bank lending expanding to new records. As a result, the Chinese authorities are tightening monetary conditions to curb inflation and restrain asset bubbles. Authorities have also instructed banks to lend less and have raised the reserve requirements for banks, an effective monetary tightening. Any further actions with respect to tightening monetary conditions are perceived as negative for Chinese demand and negative for risk appetite.

Lately there have been some concerns that better than expected data might bring even more tightening. Thus any economic indicators that will point Chinese growth is overheating can set the stage for further tightening and move investors to avert risk.

AUD, NZD- Tightening monetary conditions is bearish, higher Yuan is bullish.

EUR- Tightening monetary conditions is bearish, higher Yuan is bullish.

JPY- Depends, if the JPY is gaining on an improved economic outlook, as has happened for a few times this year when the Yen actually gained on positive news. In that case a stronger Yuan is Yen positive since if the Yuan is higher, the BoJ will feel more comfortable to let the Yen appreciate against the dollar. Why? Exporters in Asia look at the Yuan as a benchmark and try to keep their currency low as well to compete with Chinese exports. A higher Yuan should make them feel more comfortable to let their currency gain.

If however the Japanese Yen will continue to be a carry trade favorite than a stronger Yuan is JPY negative. A tightening in Chinese policy in such a scenario is Yen bullish.

Disclosures: None